What's a mortgage rate buydown? 3 things you need to know to avoid 'lighting money on fire'

Potential home buyers have been put off by rising mortgage rates, which has slowed down home sales. Sellers and mortgage lenders are trying to mimic the slow market by offering rate cutbacks and discount points to help buyers get home loans at a more affordable price.

According to Gordon Miller, President of Miller Lending Group in North Carolina, "These types of products have existed for many years and are rarely used by lenders who are desperate to satisfy a consumer's need."

So before you use a rate buydown or discount points to lower the interest rate on your mortgage, it's important to understand how they work and when it makes sense for you.

What is a mortgage rate buydown?

Discount points and buydowns (also known as mortgage points), are two ways to lower your mortgage interest rate. You can pay more money when you take out the mortgage. These terms can sometimes be interchanged. It's important that you understand the definitions of your mortgage lender when defining the buydown. Get a copy the [mortgage] notes. Miller suggests that you make sure you fully understand all terms and restrictions associated with the buydown.

What are discount points?

You permanently lower your mortgage interest rate if you pay for mortgage points or discount. Buydowns only temporarily lower it.

For each point, you'll pay 1% of your total loan amount and get a 0.25% rate drop. However, the cost and discount will vary depending on market and lender. Jennifer Beeston, senior vice president of Guaranteed Rate and mortgage educator, says that what you get from one lender can be very different from what you get with another.

What is temporary buydown?

Temporary buydowns lower the interest rate by a percentage. The rate then rises each year until it returns back to its original rate. Common temporary buydown terms include 2-1 and 1-1. The first number represents the rate reduction that you received in the first year, while the second number indicates the rate reduction for the second year.

With a 2-1 buydown, a 6.25% mortgage rate would be cut to 4.25% the first year, increase to 5.25% in year two and return to 6.25% in the third year. Here's what that looks like for a $350,000 loan balance.

Example of a mortgage rate buydown

Year 3 6.25% $2.155 $0 $0

A temporary buydown is usually paid by the seller, lender or homebuilder and effectively offsets a portion the buyer's monthly payments. The full 2-1 buydown would cost $7860, which is the amount that the buyer saves. The mortgage lender takes out the monthly payment each month from the account that was used to lower the buyer’s monthly payments. Remember that a temporary buydown does not guarantee that the borrower will be able to get a home loan. The full interest rate is required after the buydown ends.

No matter whether a rate cut is right for you, you want to make sure you get the best deal possible. There's a good possibility that you aren't comparing multiple offers from different mortgage lenders. Below are the top-rated mortgage lenders:

Here are some things you should know before getting a mortgage at a lower rate

When shopping for a mortgage, it is important to understand how rate buydowns and discount points work. An extremely low rate may be offered by a lender, but there could be discount fees. You should pay attention to the entire loan process, not just the rate.

Beeston states that hardcore rate shoppers are service-oriented and put no value on education.

It's important that you understand the terms of any discount you are receiving. While a lower interest rate may seem to save you money over the 30-year term, it doesn't take into account how likely you will be to sell your home, refinance your loan, or pay off your mortgage in a timely manner. The fees you pay upfront in each case could be higher than the amount you save. Research has shown that borrowers underestimate the length of their mortgage term.

Temporary buydowns can be a good option, since the buyer isn’t paying for the purchase. But even in this scenario, a buydown can come at the expense of other concessions for sellers. These are the three questions you should ask to evaluate the tradeoffs.

What if you refinance later and get the same rate?

Whether or not you can refinance depends on several factors, including the type of mortgage.

For conventional loans, you'll need at least 5% equity (loan-to-value of 95%) for a rate and term refinance, but you'll typically only get the best rates if you have 20% equity in your home or more. Right now there are very few cases where it makes sense to buy down the rate, Beeston says. However, if the borrower took out a conventional loan with 3% down, "I think it can make sense because if rates drop they likely will not have enough equity to refinance immediately."

FHA and VA loans offer streamlined refinance options that can make it easier to refinance than a conventional loan. This makes it less practical for these borrowers to pay a lower rate. She says, "The last thing that I want is for my veterans to spend a nickel to purchase a rate they're likely not to refinance in the next year. It's just lighting money on fire."

Every time you refinance you have to consider the upfront closing costs. Your exact closing costs vary depending on the lender, the loan, where you live and the amount you're borrowing. But refinance fees are thousands of dollars on average and can easily wipe out any potential savings you get by securing a lower rate.

You may be able negotiate with the lender to get credits to pay your fees in return for a higher rate of interest. Lender credits can be thought of as reverse discount points. You may be eligible to use them to reduce fees when refinancing.

2. What are you giving up for the buydown?

Recent changes in the housing market have seen sellers working harder to attract buyers. Beeston states that because of the market, Beeston encourages clients to make the seller pay closing costs. This has been a great success.

Just keep in mind that when sellers offer a buydown, that money has to come from somewhere. And funding the buydown might come at the cost of the seller reducing the overall purchase price or paying for closing costs. Depending on your preferences and financial situation, those concessions may be more important to you than a buydown.

Is it a good deal?

You should ensure that the starting rate you are offered is fair with any type of discount or buydown. Compare loan offers from different lenders to make sure you get the best deal.

Miller states, "Never get one quote because the industry can function like a bad flea marketplace." Okay. I'll match it," Miller says.

Bottom line

With mortgage rates sitting at twice what they were just over a year ago, it can be tempting to do everything in your power to get a lower rate. But your interest rate is only one aspect of your home loan and the home-buying process in general. You'll want to pay attention to your mortgage's closing costs because the fees you pay can wipeout the potential savings from securing a lower mortgage rate.

If you're considering taking advantage of a rate buydown or discount points, be sure you fully understand what you're getting, what it costs and what you may have to give up to get it.